What the Fed Refuses to Acknowledge

Last week we learned that consumer prices rose at a faster pace than expected for the first time in several months. The Consumer Price Index, or CPI, rose 1.9% in August compared to the same month last year. If we exclude the volatile food and energy categories, the CPI rose at a 1.7% rate. The consensus expectations had been 1.8% and 1.6%, respectively. Interestingly, there wasn’t much reaction in the bond market. Treasury yields have risen modestly since the report, but the increases represented the continuation of a trend that started about a week prior. The measured response seems to suggest that investors are not particularly worried about a sudden surge in inflation. Rather, they appear to believe that as long as key inflation metrics (the Fed’s preferred metric is the PCE deflator, which rose just 1.4% in July on both a headline and core basis) remain firmly below the Fed’s inflation target of 2%, we can expect that the Fed will go very slow in removing policy accommodation through interest-rate increases and bond sales. Are investors right to be unconcerned about inflation?

We have argued, and continue to argue, not that inflation is on the cusp of breaking sharply higher, but rather that the breakdown of inflation has been, and continues to be, troublesome. The increases in the overall CPI continue to be driven by big increases in the prices of non-discretionary goods and services while inflation in discretionary goods and services remains virtually non-existent. Why is this a problem? Because non-discretionary goods and services are the things that all of us need to buy in order to live. As middle class incomes have stagnated for the past many years, these families have had to pay higher prices for things like medical care, child care, food, rent, tuition, etc. As such, it’s not a mystery why there has been such widespread discontent across the country in recent years. Even as measures of consumer confidence have soared in recent months, most folks have not seen the income gains necessary to offset the rise in prices for critical goods and services.

Source: US Bureau of Labor Statistics

The second troubling inflation trend is the dramatic rise in asset prices and its effect on middle-class savers. We are all painfully aware that our savings and money-market accounts have been earning next to nothing in recent years as a result of Federal Reserve “stimulus” initiatives. The Fed’s suppression of interest rates has forced savers into riskier assets such as stocks, bonds and real estate. This trend has led to huge gains in asset prices for those that own the assets. On the surface, rapid price increases for financial assets like stocks and bonds may not seem like a bad thing for the investing public. After all, the higher stocks and bonds go, the closer investors are to achieving their retirement goals. Indeed, this is the narrative that some central bankers and politicians like to repeat.

But the problem with this narrative is that huge swaths of the investing public have very little savings as a result of the aforementioned years of stagnant income growth and rising expenses. As a result, most of these folks have not participated much in the stock and bond rallies. Unfortunately, through little fault of their own, these under-invested folks find themselves in a situation whereby they must accelerate their saving at a time when asset prices are quite high, historically speaking. History tells us that one of the best predictors of future investment returns is the valuation level at the inception of the investment. In layman’s terms, this means that I can expect far lower returns from an investment in an S&P 500 index fund, for instance, if I buy the fund when it’s trading at 20x earnings as compared to a much lower valuation of 12x earnings. The same goes for bonds and real estate. If I buy when prices are high I can expect lower future returns. Therefore, I may have to save MORE, not less, in order to achieve my retirement goals. This is why, in our view, asset price inflation needs to be a bigger part of the conversation at the Fed.

To illustrate the point, I ran some numbers using these assumptions:

I am a 35-year old with $100,000 in savings and I wish to retire in 30 years at age 65

My goal is to have $1,000,000 in savings, adjusted for expected inflation of 2% annually, on my retirement date

I am going to invest all my savings in an S&P 500 index fund

I expect the S&P 500 companies to collectively produce 6% earnings growth annually starting with the consensus estimate of $131.20 for 2017

At its current level of 2,500, the S&P 500 is trading at 19.1x the consensus estimate for 2017

For simplification, we are ignoring the implications of taxes

The following table shows the cumulative amounts that I will have to contribute to my account based on different beginning and ending P/E ratios for the S&P 500. For instance, at the S&P 500’s current valuation of 19.1x the expected $131.20 in earnings for 2017 and an expected terminal P/E ratio of 15x in 30 years, I would have to make total contributions (not adjusted for inflation) of $847,951 over the next 30 years in order to have $1 million in inflation-adjusted savings on my retirement date (age 65). However, if the S&P 500 were currently trading at just 12x the expected $131.20 in earnings for 2017, I would have to contribute just $571,063 over the course of the next 30 years. That’s a pretty dramatic difference.

Source: FMW Analysis (illustrative purposes only)

The financial standing of middle-class America continues to be negatively affected by 1) relatively stagnant income growth; 2) high relative inflation rates for non-discretionary items; and 3) the effect of current high asset prices on future investment returns. Possible future changes to entitlement programs could further affect the middle class. In our view, those that see the massive rally in asset prices as an unambiguous positive are not getting the whole picture. Straight up may be good for some, but it’s not a tide that is lifting all boats. It can be especially intimidating to those not even in a boat.

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